4 Things To Ponder This Weekend

As we enter into the two final months of the year, it is also the beginning of the seasonally strong period for the stock market. It has already been a phenomenal year for asset prices as the Federal Reserve's ongoing liquidity programs have seemingly trumped every potential headwind imaginable from Washington scandals, potential invasions, government shutdowns and threats of default. This leaves us with four things to ponder this weekend revolving around a central question: "Does the Fed's Q.E. programs actually work as intended and what are the potential consequences?"

David Einhorn of Greenlight Capital turns his attention to Ben Bernanke with three primary questions:

"We maintain that excessively easy monetary policy is actually thwarting the recovery. But even if there is some trivial short-term benefit to QE, policy makers should be focusing on the longerterm perils of QE that are likely far more important. Here are some questions that come to mind:

How much does QE contribute to the growing inequality of wealth in this country and what are the risks this creates?

How much systemic risk does the Fed create by becoming what Warren Buffett termed 'the greatest hedge fund in history'?

How might the Fed's expanded balance sheet and its failure to even begin to 'normalize' monetary policy four years into the recovery limit its flexibility to deal with the next recession or crisis?"

Nouriel Roubini, a professor at NYU's Stern School of Business, plays tag team with David Einhorn questioning the policies and programs of not only the Federal Reserve but of all global central banks.

"As below-trend GDP growth and high unemployment continue to afflict most advanced economies, their central banks have resorted to increasingly unconventional monetary policy. An alphabet soup of measures has been served up: ZIRP (zero-interest-rate policy); QE (quantitative easing, or purchases of government bonds to reduce long-term rates when short-term policy rates are zero); CE (credit easing, or purchases of private assets aimed at lowering the private sector's cost of capital); and FG (forward guidance, or the commitment to maintain QE or ZIRP until, say, the unemployment rate reaches a certain target). Some have gone as far as proposing NIPR (negative-interest-rate policy).

And yet, through it all, growth rates have remained stubbornly low and unemployment rates unacceptably high, partly because the increase in money supply following QE has not led to credit creation to finance private consumption or investment. Instead, banks have hoarded the increase in the monetary base in the form of idle excess reserves. There is a credit crunch, as banks with insufficient capital do not want to lend to risky borrowers, while slow growth and high levels of household debt have also depressed credit demand.

As a result, all of this excess liquidity is flowing to the financial sector rather than the real economy. Near-zero policy rates encourage "carry trades" – debt-financed investment in higher-yielding risky assets such as longer-term government and private bonds, equities, commodities and currencies of countries with high interest rates. The result has been frothy financial markets that could eventually turn bubbly."

Nouriel's comments touch on a topic that has become much more "mainstream" as of late which questions whether asset prices have once again began to over inflate.

"We've seen real bubble-like markets again," he said at a panel discussion this week, according to theBloomberg news agency. "We've had a huge increase in the equity markets."

Fink and many others are concerned about the impact of the Federal Reserve's "quantitative easing" program, under which the central bank is buying $85 billion a month in government bonds and mortgage securities in hopes of stimulating economic growth. These assets have vastly expanded the Fed's balance sheet, including recently. Since Sept. 4 alone, those balance sheets have increased 4.3 percent, while the S&P 500 has increased 4.9 percent.

In other words, investors are doubling down to capitalize on the cheap money that continues to flood the market."

The financial markets have long been seen as a gauge of future economic activity. As the stock market rises the economy has also risen. However, that has not been the case over the last several years with the economy stuck at a sub-par rate of growth. Today, with the high degree of correlation between the Fed's balance sheet and the financial markets, it is getting increasingly difficult to make the case that the markets are reflecting anything but themselves.

Fraces Coppola, proprietor of the Coppola Comment, recently discussed the issues behind the Fed's inability to "taper" its current Q.E. program.

"Tapering is removing central bank support of asset prices. Unless not just the US economy but the GLOBAL economy is "on the up" at the time that tapering commences, the result of tapering will be a global fall in asset prices. That isn't going to cause hyperinflation, as the Austrian school thinks, but it would cause a global recession.

I'm afraid it is not US fundamentals, but global fundamentals that will determine the Fed's ability to taper. If the Fed tapers when the global economy is already in the doldrums, as it is at the moment, the recessionary rebound to the US economy would be considerable.

Because of the US dollar's pre-eminence (and the pre-eminence of USTs, too – we don't talk about that enough), the Fed is effectively the world's central bank. It is high time that the US accepted that its monetary (and fiscal) policies must be driven by the needs of the global economy, not just the US. The 'exorbitant privilege' is an exorbitant responsibility, too."

QE Doesn't Do Much

As I discussed this past week the reality is that the Fed is now caught in a "liquidity trap." If they begin to remove its liquidity support the markets, and the economy, roll over. The results would like be quite devastating for investors. However, continuing to push asset prices higher also will eventually end badly. It is quite the conundrum for the Federal Reserve and for investors.

While the Federal Reserve continues to push its liquidity programs, the reality is that it does little for economic growth. Nobel Prize winner Eugene Fama discussed with Rick Santelli how the only thing that really benefits from QE programs, other than asset prices, are the "expectations" of benefits on the economy. He explains, in the following CNBC interview, that there is really no reason why QE programs would have much economic impact at all.

How we got here is one thing. Apparently, getting out will be quite another. John Hussman summed this all up well:

"In regard to what is demonstrably true, it can easily be shown that unemployment has a significant inverse relationship with real, after-inflation wage growth. This is the true Phillips Curve, but reflects a simple scarcity relationship between available labor and its real price, but this relationship can't be manipulated to create jobs (see Will the Real Phillips Curve Please Stand Up). It's also true that changes in stock prices are mildly correlated with subsequent reductions in the unemployment rate and higher GDP growth. But the effect sizes are strikingly weak. A 1% increase in stock prices correlates with a transitory increase of only 0.03-0.05% in subsequent GDP, and a decline of only about 0.02% in the unemployment rate. So to use the stock market as a policy instrument, the Fed would have to move the stock market about 70% above fair value just to get 2.8% in transitory GDP growth, and a 1.4% decline in the unemployment rate. Guess what? The Fed has done exactly that. The scale of present financial distortion is enormous, and further distortions rely on the permanent belief that there is actually a mechanistic link between monetary policy and stock prices.

We know very well the mechanisms and actual historical relationships between monetary policy and financial markets, and doubt that any amount of quantitative easing will prevent a market slaughter in any environment where investors find short-term liquidity desirable (QE only “works” to the extent that zero-interest liquidity is treated as an undesirable “hot potato”). Still, the novelty of quantitative easing, and the misattributed belief that monetary policy ended the banking crisis, has created financial distortions where perception-is-reality, at least for now. We believe that the modifier “for now” will prove no more durable than it was during the tech bubble or the housing bubble."